Setting the stage for the next collapse

When the central bank pumps money into the economy and suppresses interest rates it creates incentives to speculate and invest in ways that would not otherwise be viable. At a superficial level the central bank’s strategy will often seem valid, because the increased speculating and investing prompted by the monetary stimulus will temporarily boost economic activity and could lead to lower unemployment. The problem is that the diversion of resources into projects and other investments that are only justified by the stream of new money and artificially low interest rates will destroy wealth at the same time as it is boosting activity. In effect, the central bank’s efforts cause the economy to feast on its seed corn, temporarily creating full bellies while setting the stage for severe hunger in the future.

We witnessed a classic example of the above-described phenomenon during 2001-2009, when aggressive monetary stimulus introduced by the US Federal Reserve to mitigate the fallout from the bursting of the NASDAQ bubble and “911” led to booms in US real estate and real-estate-related industries/investments. For a few years, the massive diversion of resources into real-estate projects and debt created the outward appearance of a strong economy, but a reduction in the rate of money-pumping eventually exposed the wastage and left millions of people unemployed or under-employed. The point is that the collapse of 2007-2009 would never have happened if the Fed hadn’t subjected the economy to a flood of new money and artificially-low interest rates during 2001-2005.

Rather than learning from prior mistakes, that is, rather than learning from the fact that the use of monetary stimulus to mitigate the effects of the 2000-2002 collapse led to a more serious collapse during 2007-2009 and a “lost decade” for the US economy, the 2007-2009 collapse became the justification for the most aggressive monetary stimulus to date. The damage wrought by previous attempts to artificially stimulate has resulted in the pace of economic activity remaining sluggish despite the aggressive monetary accommodation of the past several years, but it is still not difficult to find examples of the mal-investment that has set the stage for the next collapse. Here are some of them: